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Does 'Straight Up' Qualify As Volatility?

By: Michael Ashton | Monday, November 19, 2012

The stock market gained 2% today, and commodities jumped 1.25% led by energy,
metals, and softs. There was no news that could have rationally justified
such a move, and volumes were as light as they have been in two weeks. Some
commentators, grasping for straws, suggested that the decent NAHB Housing
Market Index number (up to 46 versus 41 expected, to the highest level since
2006) and modestly stronger-than-expected Existing Home Sales figure (4.79mm
versus expectations for 4.74mm) triggered the rally, but that ignores the
fact that most of the equity move was completed prior to the 10:00ET release
of these figures.

Others resolved the conundrum by saying that "apparent progress on the fiscal
cliff" led to the rally, but the only progress made was that neither side
was hurling epithets at the other in public. There is no sign of any agreement
being made, and certainly no chance of any agreement being made that would
persuade investors with big gains to avoid realizing taxes this year (since
it is exceedingly unlikely that the upper end of the tax structure will be
unchanged or lower next year). Now, I'd suggested last week that "this is
mostly a cycling of positions, a re-setting of tax basis at a higher level,
and shouldn't amount to a major selloff by itself," but there are other reasons
to be less-than-exuberant about the market's immediate prospects too.

One of these is the conflict in and around Israel and the territories under
her control. While there is loose talk about a 'cease-fire,' Israel
is demanding a long-term agreement to stop the rocket fire and Hamas is
saying "Israel started it." I think it says something about our political
discourse here that it is probably easier to resolve the Israeli-Gaza-Syria-Egypt-Iran
conflict than to resolve the Fiscal Cliff discussions, but also keep in mind
that Israel still wants to do something about Iran's nuclear capabilities,
so a cease-fire strangely may not be in her interest at the moment.

There is no doubt that our domestic housing market is getting better, to be
sure. I've pointed out periodically (see here, here,
and here for
example ) that home prices are rising again and not surprisingly that is making
home builders happy again. The chart below (source: Bloomberg) shows the NAHB
index I alluded to earlier.

It looks suspiciously like the chart of home builder Toll Brothers (TOL) shown
below (source Bloomberg), suggesting that there is not a lot of true analysis
going on among the buyers of that stock. Toll Brothers has a current P/E of
61 on trailing earnings, and 50 on estimated forward earnings. I don't have
a position in TOL, nor do I plan to; I just point this out in case your child
was thinking of becoming an equity analyst. Help him or her along a different
path.

Part of the reason for today's surprise in home builder sentiment might be
the sudden promise of new home building activity along parts of the eastern
sea board, courtesy of Sandy, but the trend has been well established for
a while. While there is ample inventory of existing homes (though these are
being drawn down as well, slowly), the inventory of new homes has been
at a 50+ year low for more than a year (see chart, source Bloomberg) and it
was just a matter of time before more were built. An existing home is a good,
but imperfect, substitute for a new home.

Now, as an inflation guy the reason I care is because the decline in
home inventory, coupled with virtually free money for builders and home buyers
who can qualify, is pushing up the cost of a big chunk of the consumption
basket. Owner's Equivalent Rent (which is 60% of housing, which in turn is
40% of CPI) has been rising at slightly faster than that of core inflation.
As the chart below shows, there is a distinct relationship between prices
in the market for existing homes and the general increase in rents (both direct
and imputed) 15 months later.

It's not a new story, but rather one I've been talking about for some time,
and remains a key reason I remain bullish on inflation despite global central
bank protestations (and asset manager convictions, as far as I can tell) that
deflation is a more proximate threat.

Meanwhile, other economists have concluded that the reason inflation has been
rising rather than falling despite huge amounts of slack globally must be
that ... their Phillips curve needs recalibration. In a recent funny note
by Goldman's economics group - though it was not meant to be funny
- entitled "A Flatter and More Anchored Phillips Curve," they said

"We have long argued that labor market slack would weigh heavily on inflation
in the aftermath of the Great Recession. This view has generally worked
well as core (ex food and energy) inflation has fallen substantially since
2007. But the decline in core inflation abated in late 2010 and -- despite
recent signs of renewed disinflation -- core inflation has generally been
stickier than the large amount of slack would have suggested.

"A candidate explanation is that the inflation process (or "Phillips curve")
has changed in recent years. Economists have argued for some time that
improved central bank credibility, globalization and downward rigidity
of nominal wages have altered inflation dynamics since the inflationary
1980s.

Considering that the Great Recession didn't really kick in until late 2008,
and core inflation (ex-shelter, which was suffering from the implosion
of a giant bubble)rose from 2007 until late 2009, another 'candidate
explanation' would be that their model was not mis-calibrated but rather completely
mis-specified. The Phillips Curve, which relates wages, not core inflation,
to slack in the labor market, is not useful in forecasting inflation. This
is well known, and yet expensive economists have worked incredibly hard to
resurrect the theory. (Here's
a fuller illustration/explanation of why the Phillips Curve as typically
used is wrong).

But beyond that - if you need to keep changing the calibration of your model
to fit the facts, then it's not a good model. That's sort of Modeling
101. The economists explain/plead further:

Economic principles suggest that core inflation is driven by two main factors.
First, actual inflation depends on inflation expectations, which might
have both a forward-looking and a backward-looking component. Second, inflation
depends on the extent of slack (or spare capacity) in the economy. This
is most intuitive in the labor market: high unemployment means that many
workers are looking for jobs, which in turn tends to weigh on wages and
prices. This relationship between inflation, expectations of inflation
and slack is called the "Phillips curve."

Well, no. Economic principles suggest that inflation is mainly driven by money
and the velocity of money. Some discredited principles suggest what
they say, but it's not working. Their own chart, showing they're off
by some 100%, is reproduced below.

On to happier items. In case anyone still thought France was a AAA nation, Moody's
announced their opinion this afternoon that it is not, in downgrading
the nation from Aaa to Aa1. Moreover, France remains on watch negative,
due to structural challenges and a "sustained loss of competitiveness" in
the country. I guess on second thought, that's not so happy. How did France
lose competitiveness? Do you think it has anything to do with the incredibly
expensive social contracts and the short working week and year? But no,
perhaps they didn't spend enough on education and national health
care.

Michael Ashton is Managing Principal at Enduring
Investments LLC, a specialty consulting and investment management boutique
that offers focused inflation-market expertise. He may be contacted through
that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist,
and salesman during a 20-year Wall Street career that included tours of duty
at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation
derivatives markets and is widely viewed as a premier subject matter expert
on inflation products and inflation trading. While at Barclays, he traded
the first interbank U.S. CPI swaps. He was primarily responsible for the creation
of the CPI Futures contract that the Chicago Mercantile Exchange listed in
February 2004 and was the lead market maker for that contract. Mr. Ashton
has written extensively about the use of inflation-indexed products for hedging
real exposures, including papers and book chapters on "Inflation and Commodities," "The
Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven
Investment For Individuals." He frequently speaks in front of professional
and retail audiences, both large and small. He runs the Inflation-Indexed
Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes
for client distribution and more recently for wider public dissemination.
Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University
in 1990 and was awarded his CFA charter in 2001.